Canadian Currency Hedge Strategy

byBrad FerrisonMay 11, 2009

I’ve mentioned a few times in past posts the importance of identifying unsustainable trends in the economy and business cycles of companies. Every investor needs to be proactive in their investing activities to identify risk because far too often each of us are solely reactive to developments in the market and this leads to significant losses of our capital and opportunity for gains. Trees never grow to the sky and when a stock chart or market goes parabolic gravity has a sickening effect on the scale and speed of its inevitable descent.

I practice diversification by investing outside of Canada and this directly exposes me to varying degrees of currency risk each time I purchase a foreign stock, bond, mutual fund or ETF. As a long-term investor I recognize that volatility in FOREX (foreign exchange) comes with the territory of being diversified globally and that over the long-term currency fluctuations tend to even out. But as an investor in the accumulation phase of his portfolio construction I’m concerned about the short-term effect of currency volatility because it can impact the price I pay for an investment and any gains (income, capital gains, interest) I subsequently receive. While I view currency exchange as a cost of investing I want to always minimize my exposure to costs as much as possible because costs directly impact my ability to achieve short-term gains and compound long-term results.

Calculating a fair-value for what you want to pay for any foreign currency is difficult, but I tend to look to historical averages to get a sense of how far in one direction or another the specific currency has moved. Last year the Canadian Dollar (CDN$) traded well above its historical average to a high near $1.13US and you didn’t have to be an economist to figure out the dramatic effect that would have on our export economy; the valuation was unsustainable. My expectation of where the CDN$ will trade over the next decade or more is between $0.75-0.85US and if I have an opportunity to trade my loonies at par with the USD I view that as a key short-term opportunity. My expectation is that in the future when I contribute to my RSP to invest in US stocks I’ll likely get $0.75-0.85US for each CDN$. The problem for many investors is that they buy US stocks with CDN$’s, receive dividends in USD and then convert that those dividends back into CDN$’s. The costs incurred from all these activities can add up quickly and significantly diminish investor returns.

In my situation I’ve chosen to keep all foreign equities and fixed income investments in my RSP to minimize taxation (exempt from 15% withholding tax), decrease my foreign currency costs and maximize compounding growth. The only time I purchase USD is when I make a contribution to my RSP and all subsequent dividends are paid and maintained in USD within the account.

Although I believe that over the long-term (20-30 years) currency fluctuations cancel each other out any short-term devaluation of the CDN$ will hurt my ability to contribute the same amount of cash to my RSP for USD denominated purchases.

What I wanted to do was hedge to some degree my recent RSP contributions and planned contributions for 2008-2010 as I expected the CDN$ to depreciate back towards a more sustainable level. It would be difficult to completely hedge my entire position (too costly), but with oil at an apparently unsustainable bubble and the CDN$ moving so closely instep with the price of crude oil (in USD) I decided to place a small hedge in my RSP to help buffer any potential slide in currency valuations. My major motivation for this move was to maintain my purchasing power within the RSP without losing a significant value of it in CDN$’s. The intention of the hedge is to act as an insurance policy. If the valuation of the CDN$ doesn’t change I don’t need the hedge and can eventually sell it for only a loss of opportunity cost. If the CDN$ depreciates significantly I can sell the hedge off in pieces and use/combine the proceeds to make purchases within my RSP to offset the unhedged loss of value in CDN$ when I make new contributions to my RSP account. When I contribute new money from outside my RSP (in CDN$) the loss of purchasing power isn’t as significant because the hedge acts as a balancer.

Example:

Say I contributed $5,000 CDN to my RSP at parity, received $5,000 USD and purchased my hedge for the full amount. In twelve months the parity between currencies has now moved so that the CDN$ is worth $0.80US. What I can now do is contribute the same amount to my RSP in CDN$ ($5,000) as before and sell $1,000 of my hedge to achieve my desired contribution of $5,000 USD.

My choice for the hedge last summer was the PowerShares Double Short Oil ETF (DTO). The reason for choosing the double short ETF versus a regular short ETF was that I didn’t need to expose as much of my capital at risk for the same effect, the ETF was already priced in USD and the correlation of the price of oil to the CDN$ was closer than other alternatives. The effectiveness of this intended strategy was that the hedge would increase at double the decline of the CDN$. I bought the shares in July of 2008 and slowly over the past year began selling small portions of the hedge as the CDN$ and oil depreciated.

As mentioned before my intention is to not fully hedge my RSP over the long-term due to the historical ranges that many currencies range in over time and an inability of any investor to accurately anticipate the direction of valuations of currencies. But as a young investor focused on accumulating assets for future wealth I wanted to protect my purchasing power now without having to add a higher amount in contributions for the same effect. This strategy was fairly simple to implement and shows that an investor doesn’t have to do an “all or nothing” hedge. Having a small position in key investments can protect a portion of your portfolio and at times that’s all you need. The mistake many investors make is they feel they need to hedge their entire position for risk when only half or less can do the trick for the intended effect.

i was ready to rant and rave about how a young investor can stick to the canadian fixed income market, and blue chip canadian equities as a way to completely avoid the currency issue you have spent clear effort analyzing.

i was really surprised and pleased with your hedging strategy. While i personally think that the accumulation phase of portfolio management requires an extremely conservative exposure to equities, the logic- and your results- are sound.

congrats on a smart play and best of luck in the future.i would only suggest that you always keep at least a small position in some sort of oil/natural gas play to continually provide a balancing of your portfolio net worth, and not just currency volatility, over time.

Why would a young investor stick to fixed income? That seems totally bass-ackward. Young investors who don’t need the money for decades should be, logically speaking, the most risk-tolerant group of investors, shouldn’t they?

Patrick: I have a different philosophy and investment strategy than the majority of DIY Canadian investors. Please, read my blog as i try to point out the attractive yields offered in the investment-grade corporate bond market (i didn’t say 100% fixed-income). For the young investor, starting out with a broad knowledge of bonds is essential (IMO) for building and preserving wealth.knowledge of bonds and a well-constructed portfolio offers an alternative to the typical risk/return model and volatility of the traditional asset allocation ratios.

I have a similar investment strategy. Although, I am long the Canadian dollar and believe it will trade between 0.90-1 $US in the next few years. I agree that we have a petro-dollar and thus invested in HOU.TO to hedge my currency exposure.

The selection of the oil short etf is an ingenius concept for cdn hedging but the choice of the double short is bit questionable. If held for would get eroded by volatility as double etfs aren’t designed as long holds. If you want to minimize capital, options can be used on currency/oil ETF’s.

The constant leverage trap of double ETF’s will more than likely outweigh the hedge itself.

Locke – The hedge worked out exactly as it was intended regardless of the knocks against any double lever’d ETF strategy. The fact I chose a double leveraged ETF was to reduce my risk (exposure to capital) in return for recognizing the tracking error of the product. It didn’t hinder any performance vs. taking a larger position in a straight hedge.

Sami – please read the post. I’m contributing CDN$’s to my RSP and buying USD assets (equities). The hedge is intended to maintain my purchasing power when I contribute to my RSP regardless of where the valuation of the currency goes. I am neither bearish nor bullish on the movement of any foreign currency; simply limiting my exposure to risk.

@BIGINTOBONDAGE: Sorry, I'm sure you have lots of good stuff to say on your blog, but I have a bit of a problem clicking on some random link called BIGINTOBONDAGE at work… Do you have specific blog posts you'd recommend to me?